Chapter 10 Making Capital Investment Decisions

2633 Words May 10th, 2011 11 Pages
Key concepts and skills
Project Cash Flows
Relevant Cash Flows
The Stand-Alone Principle

Incremental Cash Flows
Sunk Costs
Opportunity Costs
Side Effects
Net Working Capital
Financing Costs
Other Issues

Pro Forma Financial Statements and Project Cash Flows
Getting Started: Pro Forma Financial Statements
Project Cash Flows
Projected Total Cash Flow and Value

More about Project Cash Flow
A Closer Look at Net Working Capital
Depreciation

Evaluating Equipment Options with Different Lives

Project Cash Flows

Relevant Cash Flows

Cash flows that occur (or don't occur) because a project is undertaken. Cash flows that will occur whether or not we accept a project are not relevant.

Incremental cash flows
Any and all changes
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Accounts payable also tends to increase to support the higher inventory levels; however, the cash flows associated with these increases do no appear on the income statement. If they aren't on the income statement, they won't be part of operating cash flow. So, we have to consider changes in NWC separately. Later, as projects end, this investment is often recovered.

Financing costs
Ignore! We generally don't include the cash flows associated with interest payments or principal on debt, dividends, or other financing costs in computing cash flows. Financing costs are part of the division of cash flows from a project to providers of capital and are reflected in the discount rate used to discount the project cash flows.

Other Issues

Use after-tax cash flows, not accounting numbers.

Note: Investing in fixed assets differs from investing in financial assets in at least one important sense. It is easy to find the investment opportunity and then perform an analysis to decide among competing opportunities. Preparation of a capital budget, on the other hand, requires that people investigate and develop new project proposals, estimate the cash flows associated with these projects, and only then perform the analyses. Developing reliable cash flow estimates ranges from being a relatively minor task (say a simple replacement project) to one that is subject to a great deal of uncertainty.

Pro Forma Statements and Cash Flow

Proposed Project – example…

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